Key takeaways
Solid consumer spending and strong corporate earnings continue to bolster stock prices even as higher interest rates persist.
Markets anticipate the first Fed rate cut to occur in September 2024.
With expectations that interest rates may have peaked, leadership in the stock market showed signs of rotating away from large-cap stocks.
Interest rates appear to have taken a back seat to other fundamentals.
“Interest rates are a secondary concern for investors today,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The key factors for driving equity markets higher are corporate earnings and ongoing economic growth.”
“Consumer spending and business capital expenditures remain strong, and that’s a reason for bullishness about stocks in the near term,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management."
U.S. stocks, as measured by the benchmark S&P 500, rallied to new all-time highs repeatedly over the course of 2024’s first seven months.1 For much of the year, large-cap stocks significantly outpaced mid-cap and small-cap stocks. “One factor driving this trend was the impact of higher financing costs, directly related to today’s elevated interest rates,” says Haworth. “This disproportionately affects smaller companies that have limited cash reserves and need to issue debt more frequently.” Elevated borrowing costs can chip away at a company’s profitability.
Haworth says although rates remain high, companies are under less pressure. “The market adapted to current interest rates, and is prepared for the next move in rates to be lower.”
The stock market’s sharp downward trend began after the Federal Reserve (Fed) initiated a series of increases in the short-term federal funds target rate it controls. That resulted in the rate moving from near 0% in early 2022 to a range of 5.25% to 5.50% following the Fed’s last rate hike in July 2023. However, the Fed has held rates steady since. Markets now anticipate that the Fed’s policymaking body, the Federal Open Market Committee (FOMC), will initiate fed funds rate cuts at its September meeting.2
How are interest rates likely to impact the stock market going forward?
The Fed plays a role in managing key components of the U.S. economy, including moderate inflation, full employment and a modest level of long-term interest rates. As of June 2024, inflation over the previous 12 months stood at 3.0%, much lower than its mid-2022 peak of 9.1%, but not yet down to the Fed’s 2% target.3 Fed officials are concerned that inflation has not managed to yet dip below 3%; it has stayed in a range of 3% to 3.7% since mid-2023.
Haworth says it’s helpful to distinguish between rates the Fed controls and longer-term bond rates, such as the 10-year Treasury note yield. Yields on 10-year Treasuries rose from 4.20% in late March 2024 to 4.70% in late April, but have trended lower since, back down to 4.20% in late July. That was an encouraging sign for equity markets.
Today’s interest rate environment can mean different things to different kinds of companies. “When interest rates first moved higher in 2022, it took its largest toll on stocks with already high valuations,” says Haworth. That included growth-oriented technology stocks that prospered in a low interest rate environment. “Higher rates mean investors are inclined to pay less for a dollar of future earnings in a company because they can earn more competitive current yields in lower volatility investments like cash and bonds,” says Haworth. “In 2023, as interest rates appeared to be approaching peak levels for this cycle, the impact shifted.” As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and started 2024 in an even stronger position. Smaller stocks began to turn the tide in July 2024, and regained ground on large-cap stocks, narrowing the performance gap. This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
While interest rate trends can influence the stock market, recent performance appears to be more closely tied to the strength of the U.S. economy. “As the Fed raises interest rates, we typically expect slower economic growth,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Surprisingly, however, U.S. gross domestic product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%). Growth slowed modestly to an annualized 1.4% rate in 2024’s first quarter, but gained momentum in the second quarter, growing at an annualized 2.8% pace.4 “Consumer spending and business capital expenditures remain strong, and that’s a reason for bullishness about stocks in the near term,” says Freedman. He notes that businesses appear committed to getting “bigger, stronger and faster through technology spending,” much of it centered on artificial intelligence applications. That’s provided a solid boost to technology-oriented stocks.
Yet, interest rates are still a consideration for equity investors. Stock prices tended to track with bond yield trends over the course of 2023 and 2024. When interest rates rose, stock prices retreated, and when rates fell, stocks reacted favorably. Haworth says the recent rally in small-cap stocks reflects the market’s anticipation of Fed rate cuts and continued favorable trends in the direction of long-term interest rates.
Fed Chair Jerome Powell, in recent statements, opened the door to potential Fed rate cuts, saying “three (inflation) readings in the second quarter….do add somewhat to confidence” about the environment becoming more favorable for rate cuts.4 However, Powell has not been firm about when the first cut may occur.5 “The Fed may not go very deep with interest rate cuts at this time,” says Freedman. “Economic growth and projections of future growth may dictate the Fed’s actions.”
While market interest rates may fluctuate in the near term, with some ramifications for stocks, it isn’t the only factor equity investors should consider. “Interest rates are likely to begin falling as inflation softens,” says Haworth. “A key factor is whether inflation declines because the economy stalls, or if it is a matter of prices softening within the context of a still-growing economy.” Haworth says the latter scenario is more beneficial for equities.
As you assess your own circumstances, be prepared for potential stock price fluctuations in the near term. Nevertheless, assuming that current inflation trends endure and the economy can hold its ground, stocks should continue to represent a key component of any diversified portfolio for long-term investors. “In part, this is due to the fact that equity returns can help investors keep pace with inflation,” says Haworth.
Talk with your wealth professional about your comfort level with your portfolio’s current mix of investments and discuss whether any changes are appropriate in response to an evolving capital market environment consistent with your goals, risk appetite and time horizon.
Note: The Standard & Poor’s 500 Index (S&P 500) consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P 500 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The Russell 2000 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.
Interest rates can affect stock markets in different ways. Frequently, when rates rise, equities are challenged because investors can choose to invest in bonds that pay more attractive yields than was previously the case, rather than stocks. Higher rates can put pressure on stock valuations, as corporations may need to generate more attractive earnings to capture investor interest. Another way the interest rate environment affects stocks has to do with companies’ bottom lines. If a debt-issuing company faces higher borrowing costs due to rising rates, it may result in reduced company profits, which can be reflected in lower stock prices. These factors are among the reasons why equity investors pay close attention to the interest rate environment.
If the Federal Reserve raises the short-term federal funds target rate it controls (as it did in 2022 and 2023), it can have a detrimental effect on stocks. A higher interest rate environment can present challenges for the economy, which may slow business activity. This could potentially result in lower revenues and earnings for a corporation, which could be reflected in a lower stock price.
There is not a direct correlation on the direction of interest rates stemming from stock market movement. The state of the economy and inflation are bigger factors that help determine the direction of interest rates. In many circumstances, interest rate movements can affect stock prices. The biggest impact stock prices have on interest rates is on the demand for bonds. If stock prices decline, it may indicate investors are seeking to reduce portfolio risk and putting more money to work in bonds. This reflects an increase in demand for bonds, which typically allows issuers to offer debt at lower interest rates.
With inflation retreating and likely interest rate cuts coming soon, how should investors position their portfolios to capitalize on potential opportunities, while guarding against risks?
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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